Under/over-valuation of the stock market and cyclically adjusted earnings

Marco Taboga (marco.taboga@bancaditalia.it)
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Marco Taboga: Bank of Italy

No 780, Temi di discussione (Economic working papers) from Bank of Italy, Economic Research and International Relations Area

Abstract: The ratio between current earnings per share and share price (the EP ratio) is widely considered to be an effective gauge of under/over-valuation of a corporation�s stock. Arguably, a more reliable indicator (the cyclically-adjusted EP ratio) can be obtained by replacing current earnings with a measure of �permanent earnings�, i.e. the profits that the corporation is able to earn, on average, over the medium to long run. I propose a state-space model to filter business-cycle oscillations out of current earnings and compute the cyclically-adjusted EP ratio. I estimate the model with euro-area aggregate stock market data. I find periods, notably around the 2008 financial crisis, when the adjusted and the unadjusted EP ratios provide economically and statistically different indications. I propose a method to make the adjusted EP ratio easier to interpret by translating its values into estimates of the probability that the stock market is under/over-valued. These estimates clearly indicate periods of mis-valuation in my sample. Furthermore, some simulations suggest that the model would have been able to provide early warning signs of mis-valuation in real time.

Keywords: earnings/price ratio; cyclically adjusted earnings; undervaluation/overvaluation of stocks (search for similar items in EconPapers)
JEL-codes: C46 G10 (search for similar items in EconPapers)
Date: 2010-12
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Citations: View citations in EconPapers (1)

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Related works:
Journal Article: Under‐/Over‐Valuation of the Stock Market and Cyclically Adjusted Earnings (2011)
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